Georgetown University Law Center Business, Economics and Regulatory Policy Working Paper Series

Research Paper No. 1462895

Institute for Law & Economics University of Pennsylvania Law School Research Paper No. 09-31

SECURITIZATION: CAUSE OR REMEDY OF THE FINANCIAL CRISIS?

Adam J. Levitin
Georgetown University Law Center

Andrey D. Pavlov
Simon Fraser University

Susan M. Wachter
University of Pennsylvania

This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection at: http://ssrn.com/abstract=1462895

Electronic copy available at: http://ssrn.com/abstract=1462895

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SECURITIZATION:CAUSEORREMEDYOFTHEFINANCIALCRISIS ADAMJ.LEVITIN* ANDREYD.PAVLOV SUSANM.WACHTER ABSTRACT This article describes the causes of the boom and bust in the U.S. housing market, which brought down not just the U.S. financialsystembuttheglobaleconomy.Howdidthisviciouscycle begin? How did home prices appreciate so far and so fast? Why did rational investors not recognize and stop mispricing and investing in these loans on Wall Street? We offer a supplyside explanationofthemortgagecrisis.Attherootofthecrisiswasa new class of specialized mortgage lenders and securitizers unrestricted by regulations governing traditional lending and securitization. Eager to take profits in an originatetodistribute lending model, aggressive lenders piled in by offering loans with low upfront costs, attracting firsttime home buyers previously unable toafford houses, repeatbuyers buyingpricier homes and secondhomes,aswellasspeculators.Thesepracticesdroveprices particularlyhighinArizona,California,Florida,andNevada,which had significant landuse regulations and environmental controls that reduced supply elasticity, leading increases in demand to triggermostlyhigherpricesinsteadofagreatersupplyofhousing.

Adam J. Levitin (AJL53@law.georgetown.edu) is Associate Professor of Law at the Georgetown University Law Center. A version of this paper appearedin16WHARTONREALESTATEREV.(2009). AndreyD.Pavlov(apavlov@sfu.ca)isAssociateProfessorofBusiness atSimonFraserUniversity. Susan M. Wachter (wachter@wharton.upenn.edu) is Richard B. Worley Professor of Financial Management and Professor of Real Estate and FinanceatTheWhartonSchool.
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SECURITIZATION:CAUSEORREMEDYOFTHEFINANCIALCRISIS ADAMJ.LEVITIN ANDREYD.PAVLOV SUSANM.WACHTER

I.THENEWSECURITIZATION .......................................................................................... 3 II.NONTRADITIONAL(NONPRIME)MORTGAGES ............................................................... 6 III.ADEBTDRIVENPHENOMENON ................................................................................ 9 IV.NONRECOURSELENDING ....................................................................................... 12 V.MISALIGNEDINCENTIVES ......................................................................................... 13 VI.THENEWNEWSECURITIZATION .............................................................................. 15

Inthisfinancialcrisis,realestatehasbeenhithardand,in turn, real estate has hit individual homeowners, the financial sector,andtheoveralleconomy.Infact,thelossesinresidential mortgagebacked securities (MBS) were the proximate cause of themeltdownofthefinancialsysteminthefallof2008.Preceding this,thebubbleinrealestateassetsanddebtlaidthegroundwork for the eventual crash. Despite extraordinary countercyclical monetary and fiscal policy, as of the third quarter, housing continues to be a negative force. As of midyear 2009, home priceshavefallenapproximately30percentfromtheir peakand the stock market has plummeted twice as much.1 Because the financial sector is exposed to commercial and residential mortgages, banking and the economy depend fundamentally on thestabilityofrealestate. The root of the crisis: homeowners who could not make payments falling into foreclosure and the lenders putting these homes up for sale at fire sale prices, resulted in an increase in supply. This pushed down real estate values, which left many other homeowners with negative equitytheir homes were worth less than they owed on their mortgages. Paying a mortgageonapropertywithnegativeequityiseconomicrenting, andwithcheaperrentalratesmanyhomeownerswhootherwise

S&P/CaseShillerHomePriceIndex.

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would continue making payments despite financial reversals simply stopped making their mortgage payments and walked awayfromtheirproperties,feedingmoreforeclosures(Figure1).2 More fuel was thrown on this fire as the economy declined. As unemployment rose more mortgages became unaffordable, resultinginmoreforeclosures,andfurtherprice declinesleading tomorenegativeequity. Figure1.GrowthinForeclosures3

How did this vicious cycle begin? How did home prices appreciate so far and so fast? Why did rational investors not recognizeandstopmispricingandinvestingintheseloansonWall Street?Thisarticledescribesthecausesoftheboomandbustin the U.S. housing market that brought down not just the U.S. financialsystembuttheglobaleconomy.

See, e.g., CONG. OVERSIGHT PANEL, THE FORECLOSURE CRISIS: WORKING TOWARDASOLUTIONpin(2009) 3 MortgageBankersAssociationNationalDelinquencySurveys.
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I.THENEWSECURITIZATION

The economic circumstances that contributed to the recenthousingmarketboomandbustarenotunique inhistory. Realestateboomsandsubsequentbankingcrasheshaveoccurred intheU.S.andelsewhere,intheearly1980sinJapan,inthelate 1980s in the savings and loan crisis and as recently as the late 1990s in the Asian Financial Crisis. Moreover, the housing boom that preceded this crisis was global. Nonetheless, this time the asset and credit bubble blowout and subsequent crash were Made in the USA. Downturns in the mortgage and housing marketshavecausedeconomicproblemsbefore,butthecurrent situation is the first of its kind and severity, underscoring profoundchangesinthesemarkets. At the root of the mortgage problem was a new class of specialized mortgage lenders and securitizers unrestricted by regulations governing traditional lending and securitization. Historically,themortgagemarketwasdominatedbysavingsand loans and commercial banks. Both of these types of entities either held mortgages in portfolio or securitized them through governmentsponsoredentities(GSEs):FannieMae,FreddieMac, andGinnieMae.BecausetheGSEsguaranteethetimelypayment of principal and interest on their MBS, they are permitted to securitize only investmentgrade mortgages. This meant that lenders who made noninvestment grade loans were forced to keep the mortgagesand the credit riskon their books. Not surprisingly,lendershadlittleappetiteformakingriskierloans. The balance of the mortgage market began to change, however, in the mid1990s and a rapid transformation occurred after 2000. Lenders discovered that rather than securitizing mortgagesthroughtheGSEs,theycouldsecuritizethemthrough unregulated, private conduits managed by investment banks. These privatelabel MBS did not carry the GSEs guarantee of timely payment of principal and interest; instead, investors assumed the credit risk on these MBS, which meant on the underlyingmortgages.Theseoriginationdemandoftheseprivate
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conduits were feed heavily by thinly regulated mortgage banks andmortgagebrokers. Because private label MBS do not have the payment guarantee (with implicit or explicit government backing) of the GSEs, they were designed with other forms of credit enhancement,mostnotablythedivisionofthesecuritiesbacked by a pool of mortgages into a cashflow waterfall that allocated default risk on the mortgages by a hierarchy of tranches. The result was the creation of AAA securities from risky underlying mortgages.Theriskiesttranchesreceivedthelowestratingsfrom the credit rating agencies and therefore paid the highest yields, and they were the first to lose value if borrowers fell behind in payments. On top of this, financial firms leveraged private label MBSbyusingtheseascollateralforadditionaldebt,intheformof collateralizeddebtobligations(CDOs).FirmsoftenmadeCDOs2by pooling and tranching CDOs themselves. Leverage on top of leverageleftthesystemvulnerabletoeventheslightestdeclinein pricesorincreaseinloandefaults. The rating agencies, did not carefully analyze the underlyingcollateralofthesecuritiestoidentifytheprobabilityof default or price fluctuation. Instead, they assumed home prices would not decline by much, if at all. Since the U.S. had never experienced an economywide decrease in home prices of more than 1 percent, the agencies considered this to be a reasonable assumption, and the firms issuing the securities assumed their diversificationhadremovedanyriskofconsiderablelosses. This privatelabel securitization permitted the securitizationofnoninvestmentgrademortgages,andtherewas a market appetite for privatelabel MBS because of the higher yields they offered relative to GSE MBS. The development of a market for noninvestment grade mortgages led to a boom in their production. From the mid1990s to 2006, nontraditional (nonprime) mortgages grew from virtually zero to nearly 50 percentoforiginations.Manyofthenewloanswereweremade to borrowers who could not qualify for traditional mortgages
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because of poor credit or low incomes. Many were also originated by mortgage banks or mortgage brokers who did not holdloansinportfolio,andwhosebusinesswassolelygenerating mortgageproductforprivatelabelsecuritizationpipelines. Lendingqualityforprivatelabelsecuritizationwasdifficult tomonitoranddeclinedovertime.Becausethesesecuritieswere not backed by standardized assets, they generally did not trade. Privatelabel securities (PLS), as opposed to those issued by the GSEs, were not traded because they were nonstandardized and therefore illiquid. PLS were therefore marked to model, not to market. Evidence of misallocated investment and growing risk wasmaskedbythefactthatthelooserstandardsbuoyedhousing pricesintheshortterm. TableI.DeteriorationofLendingStandards,20022006
MortgageInformation YearofOrigination NumberofLoans(AllLoans) SubprimeLoans AltALoans LowDocLoans InterestOnlyLoans SecondLoans ARMTeaserLoans MARGIN(AdjustableRate) AllLoans 1999 596,710 512,476 84,233 120,682 1,169 86,482 172579 6 2003 1,840,040 1,426,503 413,494 678,810 95,870 192,337 361811 6 2006 3,251,355 2,376,949 872,208 1,635,176 725,317 708,343 1639509 5

Source:LoanPerformance,AnthonyPenningtonCross,etal.,WRECWRC

Moreover the erosion of lending standards was nearly impossibletoidentifyinrealtimebecausemortgageswerenon standardizedandheterogeneous.Giventhisheterogeneity,itwas notpossibletotrackthechangeinthecompositionofmortgage product or the layering of risk. And because these were not traded, there was no ability to signal this credit erosion to the market. The price bubble fueled by poor underwriting increased
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the risk exposure of the entire mortgage system given the inevitablecollapseofinflatedprices.Homepricesplummetedso sharply that by the spring of 2009, some have estimated that everyfifthborrowerowedmorethanhisorherhomewasworth and defaults rose to postwar records: almost one out of every twentyfiveborrowersisinforeclosure.Financialinstitutionswith majormortgagemarketexposurehavefailedorrequiredextreme government assistance, and even AAArated MBS tranches are trading for a fraction of face because of market uncertainty regardingfuturedefaults.Thisisthesystemicriskengenderedby securitizationwithoutregulation.
II.NONTRADITIONAL(NONPRIME)MORTGAGES

In an era of deregulation and optimism, privatelabel securitizationdrovethedemandfornewtypesofriskymortgages. For the past halfcentury, the classic U.S. mortgage charged a fixedinterestratethatstayedthesamefortheloans30yearlife. Once the mortgage papers were signed, the homeowners monthly payments never changed, making payments easier and easier to shoulder as the borrowers income rose with inflation. Generally, homevalueswentupaswell,sothe borrowerscould expecttosellatvirtuallyanytimeformorethantheyowed. This picture changed dramatically in the runup to the housingbubbleasthedemandforsecuritizedmortgagesfedthe demandforrecklesslyunderwrittenloans.Initially,MBSinvolved only prime mortgages issued to lowrisk borrowers, but then private label securitizers entered the market to pool mortgages backed by increasingly risky loans that the GSEs were not permitted to securitize. Prior to 2003, nontraditional (nonprime) mortgages never held more than 16 percent of the market; by 2006,theyhadreachedastaggering46percent(Figure2).Nearly twothirdsofallhomeloansissuedsince2003wereaggressive, entailing risks not found in conventional loans. In addition to subprime loans,this includednonamortizing,interestonlyloans where the borrower made no principal payments; low doc or no doc loans that required little or no down payment,
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documentation, or proof of income; and pay option adjustable rate mortgages (ARMs) that allowed borrowers to choose the monthly payment level, including making interest only or negativelyamortizingpayments. Figure2.MortgageOriginationsbyProduct

At the same time, the subprime market developed new products whose features had never faced a market test. This included hybrid ARMs, often known as 2/28 and 3/27 loans 30yearloanswithafixedrateteaserperiodoftwoorthreeyears andannuallyadjustedratesthereafter.Theycarriedprepayment penalties making it prohibitively expensive for borrowers to refinance when their payments got too high, such as at the expiration of the teaser period. Buyers qualified based on the initial low teaser rate, even though they might not be able to shoulder the higher payments that could come if the rate adjustedupward. The race for market share fueled the extension of increasingly risky loans to borrowers without the capacity to repay. The expansion of these aggressive loans beyond their suitable use is the real concern. AltA loans, for example, are
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riskier than prime but less riskythan subprime,. As a result they are niche products welltargeted to selfemployed homeowners. Similarly, option ARMs were originally designed for individuals withirregularincome(suchascommissions,seasonalearnings,or yearendbonuses),notasageneralmarketproduct. Aggressive lenders piled in by offering loans with low upfrontcosts,attractingfirsttimehomebuyerspreviouslyunable toaffordhouses,repeatbuyersbuyingpricierhomesandsecond homes, as well as speculators. Aggressive lending drove prices particularlyhighinArizona,California,Florida,andNevada,which had significant landuse regulations and environmental controls that reduced supply elasticity, leading increases in demand to triggermostlyhigherpricesinsteadofagreatersupplyofhousing. By 2007, it was clear that neighborhoods and cities that hadhighconcentrationsofaggressivelendingsufferedthelargest homeprice declines after the market cooled. For each one percent higher share of subprime origination in 2005, prices declined increased by 1.5 percent for that neighborhood. 4This was especially ominous for both innercity and farout drive to qualifyneighborhoodswhereaggressiveloanswereprevalent. Foratime,capitalmarketshadanappetiteforalmostany kindofrisk,aslongasparticipantsreceivedfeesfortheproducts they were manufacturing and selling. There was little understandingofthedefaultriskinthenew,fastgrowingmarket, andfirmsdidnothaveastrongincentivetofocusondefaultrisk. The bulk of new products were originatetodistribute, so they were sold off instead of held in firms portfolios. The issuer, the securitizerandtheraterwereonlyinterestedinthefeesthatthey bookedforeachsale,whichofcourselentitselftoahighvolume of shortterm profits instead of calibration of default risk and longtermloanperformance.

SeePavlovandWachter(2009b).

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III.ADEBTDRIVENPHENOMENON

There are three common explanations for Wall Streets drivetowardMBSandtheincredibleappreciationofhomeprices (Figure3).Thefirstisastoryofeasymoneylookingfortrouble.5It argues that the low interest rates set by the Greenspan Federal Reserve made borrowing so cheap that consumers rationally bought houses in droves. This explains part, but not all, of the bubble. Low interest rates allowed people to borrow more, bidding up home prices. Because home prices soared, homeownerswhoranintofinancialtroublecouldeasilyselltheir homes for more than they owed, avoiding default and foreclosure. Figure3.HomePriceIndex(CaseShiller)

Interest rates do not tell the whole story, though. Even while the Fed was lowering interest rates, the rest of the world was experiencing the same cheap credit. By 2003, U.S. interest rates began to rise, and home price appreciation slowed throughout the worldexcept in the U.S., where home prices continuedtoacceleratedespiterisinginterestrates.Cheapcredit

Adam J. Levitin, Foreword, The Crisis without a Face: Emerging Narratives of the Financial Crisis, 64 MIAMI L. REV. (2009). See, e.g., RICHARD POSNER, FAILURE OF CAPITALISM: THE CRISIS OF '08 AND THE DESCENT INTO DEPRESSION (2009).
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helps explain the beginning of the boom, but the magnitude of thebubbleandburstcyclerequiresafullerexplanation. Thesecondexplanation,advocatedbyEdGlaeser,Joseph Gyourko,andAlbertSaiz,arguesthatsupplyhasbecomeinelastic intheUnitedStates,soincreaseddemandbidpricesthroughthe roof instead of increasing the quantity supplied.6 While this is certainlytrue(asindicatedinthediscussionoftheeffectofland useregulations),thishousingfocusignorestheroleofthesupply ofcapital,alinkwhichwewilladdressshortly.Arelatedrationale has been put forth by Robert Shiller that irrational exuberanceoranimalspirits,tousethetermheandGeorge Akerlof borrowed from John Maynard Keynesblinded consumers to the bubble, so they bid prices higher and higher, thinkingtheywouldneverfall.7 The third explanation pins the blame on the affordable housing policies of the GSEs and the Community Reinvestment Act. This argument holds that government encouragement of homeownershipincentivizedfinancialinstitutionstomakeriskier loans, with disastrous results.8 It is important to remember, however, that regulation prevented the GSEs from issuing MBS basedonsubprimemortgages.Infact,theGSEsdidnotarriveon the subprime scene until 2005well after the bubble had begunand then only by buying socalled AAA and AltA tranches of subprime CDOs for their portfolio. In this regard, shareholdersandCongressdeservetheblameforpressuringthe GSEs in this direction, and their safety and soundness regulator, the Office of Federal Housing Enterprise Oversight (OFHEO)

Edward L. Glaeser et al., Housing Supply and Housing Bubbles, at http://www.economics.harvard.edu/faculty/glaeser/files/bubbles10jgedits NBER%20versionJuly%2016,%202008.pdf(July16,2008draft). 7 Robert Shiller, THE SUBPRIME SOLUTION: HOW TODAY'S GLOBAL FINANCIAL CRISISH APPENED,ANDWHATTODOABOUTIT(2008). 8 See, e.g., Stan Leibowitz, Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, Oct. 3, 2008, at http://www.independent.org/publications/policy_reports/detail.asp?type=full &id=30.
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deserves the blame for not stopping them (though, in fairness, Congress gave OFHEO very little power to do so). The GSEs thereforeaddedalotoffueltoanalreadyragingfire,byaddingto the demand for subprime MBS, but bear less responsibility for startingthecrisis. Two of usAndrey Pavlov and Susan Wachterhave offered a fourth explanation: because the price of risk (represented by the yield rates of MBS) fell during the housing bubble,wecannotconcludethatitwassimplyarightwardshiftin the demand curve for housing, as the first two explanations suggest, or else increased demand would have generated higher rates for MBS.9 Instead, it must be the case that supply of mortgage capital increased more than demand, which is consistent with the observed lower cost of capital according to standard economic theory. Specifically, Wall Street firms must havebeensupplyingMBSatsuchahighpacethatitexceededthe high demand for houses. In other words, the demand for mortgages,whichdrovehighhomeprices,wasledbyWallStreet, whichneededthemtocreateandsellMBS.Why,then,wasWall StreetsoeagertoproduceMBS? Shortterm incentivessuch as originationfocused compensation packages and trader bonuses geared toward end ofyear revenues instead of any long run measure of performanceencouraged financialfirmstosell MBSforaquick profitatarapidpaceand highvolume.Thecreditboomcreated by the Fed, as earlier suggested, played an important role in initiatingthepriceappreciation,butWallStreetshungerformore mortgages ratified it. The mortgage crisis was born of both a demandside and a supplyside boom that led to a realtime erosioninlendingstandards.

See Pavlov, Poznar, and Wachter (2008); Pavlov and Wachter (2009b);andPavlovandWachter(2009c).
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IV.NONRECOURSELENDING

Because most American mortgages are effectively non recourse,10 a borrower who defaults stands to lose only the collateralthatis,thehouseandanyequitytheyhaveputinto thehouse(which isasunkcostanyway).Theborrower,inother words, is not personally liable for the full amount of the loan in default.Anotherwaytolookatthisstructureisthroughthelens of a put option. When a bank makes a nonrecourse loan, it implicitly provides a put option on the underlying asset. If the valueoftheassetdeclines,theborrowerhastheright,butnotthe obligation,toputtheassetbacktothebank(thatis,walkaway from the property). In other words, the borrower can sell the assettothebankfortheoutstandingloanbalance.Thisrightto selllimitsthelossesoftheborrowerandisaputoption,written by the bank, with a strike price equal to the outstanding loan balance. Iftheputoptionispricedcorrectly,anditspriceispassed ontotheborrowerintermsofahigherinterestrate,lendinghas no impact on asset prices, that is, property values. If the put option imbedded in a loan is underpriced, that is, if the interest ratechargedistoolowrelativetothedepositrate,theninvestors incorporatethismistakeintheirdemandpricefortheasset.Thus lendingwithoutproperlypricingtheputoptionresultsininflated price of the asset even within efficient equity markets. Once lenders began to issue mortgages with loantovalue ratios greater than one, mortgages were almost inthemoney put optionsimmediatelyatthepointoforigination. Managers inability to correctly value the put option results in underpricing, but managers who underprice the put option are discovered only in case of financial crisis when homeownersarelikelytoexercisetheoption.Absentsuchcrisis,

Andra C. Ghent & Maryanna Kudlyak, Recourse and Residential MortgageDefault:Theoryand Evidencefromthe UnitedStates,Fed. Reserve BankofRichmondWP0910(2009).
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managershaveanincentivetounderpricetheputoptioninorder toincreasetheprofitsingoodstates.Longtermmanagershavea lottoloseiftheyunderpriceandarediscovered.Thus,longterm managerswouldnotunderprice.Shorttermmanagers,however, haverelativelylittletoloseiftheirunderpricingisdiscovered.For them,thebenefitofincreasedprofitsintheshortrunissufficient tounderprice.Infact,aswehavepreviouslyshown,thepresence of shortterm managers puts sufficient competitive pressure on the industry that all managers underprice the put option, regardless of their time horizon.11 This result holds even if managers act in the best interest of shareholders, absent any agencyconflicts. Theabsenceofshortsellinginrealestateandtheabilityof optimists to drive prices up can, for example, produce price bubbles even in the absence of underpricing, but mortgage funding is necessary to sustain real estate price bubbles. The willingness and ability of the banking sector to provide underpricedfundingratifiesandexacerbatestheseinefficiencies.
V.MISALIGNEDINCENTIVES

Thekeylinkinthechain,asdescribedabove,istheshort term perspective of managers. If managers had reason to worry about the franchise value of the firm, they would not risk a financialcrisisbyunderpricingMBS.Severalfactorscontributedto thisperspective. First,thecompensationstructureatmostWallStreetfirms focusedonyearendbonusesbasedonannualprofits.Managers neededtoproduceahighvolumeofprofitsbeforeDecember31, and had no incentive to consider the systemic risk that underpricingMBSmightleadtoanunsustainablehousingbubble. Second,therewasnowaytokeepthemarkethonest.In complete markets, traders can recognize underpricing and short

See Pavlov and Wachter (2006), Pavlov and Wachter (2009a), and PavlovandWachter(2009c).
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sell the firms and assets to profit from the longterm default of the system. Real estate, however, is famously difficult, if not impossible, to short. Because financial firms kept MBS in their portfolios, they were not actively traded. Without a trading marketforMBSs,shortsellingcannotoccur.Withoutshortselling, themarketcannotindicateorcorrectunderpricing. Also,firmsattemptedtohedgetheirriskbybuyingcredit default swaps (CDS) from insurance firms like AIG and some investment banks like Lehman Brothers. CDS insured the buyer againstdefaultonaparticularunrelatedtransactioninthiscase, the mortgages underlying MBS held in the banks portfolios. A CDSbuyerpaysafeeforCDSprotection,andifthereisadefault, the CDS seller essentially purchases the defaulted debt from the protection buyer at a previously agreed price. Because the CDS buyersfeltthattheyhadhedgedtheirdownsiderisk,theyhadan incentivetocontinuetounderpriceMBS. Unfortunately, the firms underwriting CDS also underpricedrisk.Oneofaninsurersprimarydutiesistoanalyze theircounterpartyrisktodetermineasufficientpremiumtocover any eventual payments; for CDS, that means understanding the riskprofileofthetransactionsbeinginsured.Why,then,didCDS sellers like AIG and CDS buyers like Lehman fail in their primary duty? ManagersatCDSfirms,likemanagersatMBSissuers,had a compensation structure that rewarded shortterm revenues insteadoflongtermperformance.SellingCDSnowandworrying about risk later was a profitable strategy. Buying CDS now and worrying about counterparty risk later was also a profitable strategy.Furthermore,CDSbuyersmayhaveconsideredmostof their counterparties too big to fail, and so there was a moral hazard in the system that encouraged CDS sellers to issue more insurancethantheycouldcoverinthebeliefthatanyremaining losseswouldbesocialized.

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The system was essentially insolvent. Firms had underpricedMBSandcouldnotsustainthelossesofaneconomy wide housing crash. They had bought and sold CDS that did not really hedge their risk, as the buyers would be stuck with losses they could not pay, and the sellers would be forced to insure defaultsthattheydidnothavesufficientcollateraltocover.The result was a run on the bank in reverse: Managers had an incentive to get it while you can. It was the classic looting behaviordescribedbyGeorgeAkerlofandPaulRomer.12
VI.THENEWNEWSECURITIZATION

While it is clear that systemic risk derives from the pro cyclical erosion of lending standards, there is no consensus on how to avoid this. While no system is perfect, fixedrate long term mortgages with robust, standardized securitization historically has been consistent with financial stability. Standardization promotes liquidity, ensures suitability, and enhances system stability. A market and a formal trading exchange for standardizing and, if necessary, short selling real estate securities could be helpful in bringing increased liquidity, decreasedheterogeneity,andtheabilitytorecognizeandprevent creditmispricing.Butmoreisnecessary. The central question is how to prevent excesses that inevitablyleadtoliquiditycrises.BenBernankeandMarkGertler arguedin1999thatassetbubblesarenotdestructiveenoughto systemic stability to warrant monetary intervention.13 Their model,however,didnotaccountforthepossibilitythatcreditwill dry up bringing about the historical banking system panic scenario.

George A. Akerlof & Paul M. Romer, Looting: The Economic Underworld of Bankruptcy for Profit, 24 BROOKINGS PAPERS ON ECON. ACTIVITY 1 (1992). 13 Ben Bernanke & Mark Gertler, Monetary Policy and Asset Price Volatility, 1999 FED. RESERVE BANK OF K.C. ECON. REV. 17 (1999) at http://www.kc.frb.org/publicat/sympos/1999/4q99bern.pdf.
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Asset bubbles that affect the payment mechanism have repeatedlyledtoliquiditycrises.Realestateisespeciallyproneto assetbubblesbecauseofthedifficultyinshortingtheunderlying asset. Real estate bubbles are a matter of particular concern becausefinancialintermediarieslikebanksareheavilyexposedto residentialandcommercialmortgagesmakingtheentirefinancial system susceptible to real estate booms and busts. Relying on a macroprudential risk regulator may not be sufficient. Securitization has become an essential component of consumer finance and of housing finance in particular. But to make securitizationwork,clearrulesofthegameareneededthathelp achieve transparency, assure against counterparty risk and data provisiontoinformtrading.Marketscanpriceandexposerisk,if wegivethemtothetoolstodoso. Bibliography
Akerlof,GeorgeA.andPaulM.Romer(1994),Looting:TheEconomic UnderworldofBankruptcyforProfit,NationalBureauofEconomicResearch WorkingPaper. Bernanke,BenandGertler,Mark(1999),MonetaryPolicyandAssetPrice Volatility,17FED.RESERVEBANKOFK.C.ECON.REV.,1751. CongressionalOversightPanel(2009),ForeclosureCrisis:WorkingTowarda Solution,Washington,D.C. Ghent,AndraC.andKudlyak,Maryanna(2009),RecourseandResidential MortgageDefault:TheoryandEvidencefromtheUnitedStates,Federal ReserveBankofRichmondWorkingPaper. Glaeser,EdwardL.;Gyourko,Joseph;andSaiz,Albert(2008),HousingSupply andHousingBubblesWorkingPaper. Leibowitz,Stan(2008),AnatomyofaTrainWreck:CausesoftheMortgage Meltdown,inHousingAmerica:BuildingOutofaCrisis,Forthcoming.

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